Fed tightening.

15th September 2015

Ian Copelin, Investment Director, my wealth comments “Global equity markets have drifted lower this week ahead of an eagerly awaited US Federal Reserve (Fed) Federal Open Market Committee (FOMC) meeting later this week (16-17 September), with economists’ opinions evenly split on whether or not the Fed will increase US interest rates for the first time in nearly a decade.

While some economists have taken signs of slowing economic growth in China (which have weighed on commodity prices and thus driven down the global inflation outlook), coupled with recent market turbulence as reasons for the Fed to delay any interest rate increase, others see the recent US jobs data (unemployment has fallen to 5.1%) and Gross domestic product (GDP) growth (Q2 GDP was recently revised upwards to 3.7%) as a strong case to increase interest rates.

Normally the Fed would increase interest rates (or tighten monetary policy) when economic growth is strong and inflation is rising.

Although Q2 GDP growth was strong, it followed a weak Q1 when the economy grew just 0.6% having been impacted by harsh winter weather (which reduced output in many parts of the country).  Also inflationary pressures are non-existent (and one could argue that the threat of deflation is still a risk).

With regards to the recent market turbulence, the Fed has, for a long time, intimated that an interest rate rise was on the cards, while at the same time been openly wishy-washy about its timing.  I believe that this uncertainty has added to (if not created) much of the recent equity market volatility, so the argument that the Fed should not be increasing interest rates now because of the volatility is a red-herring.

I strongly believe that the Fed may opt to raise rates this month just to preserve its credibility and show the market they can, and will, raise interest rates if only to prove that they can start the journey to ‘normalization’.

As I don’t believe that the US economy is ready for the kind of traditional rate-hike cycle of the past, I would expect this to be one of the loosest tightening cycles ever (i.e. one that will involve a very shallow path of rate hikes with the high point for interest rates well below historical averages) and in fact, a September rate rise may mean that we don’t see another increase for at least 12 months.

Paradoxically, I believe it may well be ‘sell the rumour, buy the fact’ ahead of the Fed meeting as an interest rate rise may help calm market volatility and send equities higher towards the year end.

With regards to UK interest rates, there is a popular belief that once the Fed moves, the Bank of England (BoE) will follow.  However, the two central banks have different mandates:  the Fed has a dual mandate of inflation and economic growth (its goal is to achieve maximum employment, stable prices, and moderate long-term interest rates); while the BoE only has to maintain price stability (with an inflation target of 2%).

It was announced earlier today that UK consumer price index (CPI) inflation returned to zero in August, driven down by the cost of motor fuel and clothing, while core inflation (which excludes volatile energy, food alcohol and tobacco costs) slowed to 1% from 1.2%.  Consequently, with little or no inflation in the UK, there is no need to rush to increase interest rates.”